Consider the following events: a pressure tank within a rocket
propulsion system fails during a launch; tectonic plates shift, causing
the first significant earthquake in a locale for several decades; a
stock market experiences a crash after a prolonged run-up in price
levels. The commonality here is that all of these events are ultimately
characterized by a "rupture" in the underlying system,
following a buildup of "pressure" over a period of time. The
recognition of certain engineering and geologic events as analogous in
this way to financial market crashes was the impetus for the interesting
and enjoyable new book Why Stock Markets Crash: Critical Events in
Complex Financial Systems, by Didier Sornette.

The major thesis of this book is that a stock market crash is not
the result of short-term exogenous events, but rather involves a
long-term endogenous buildup, with exogenous events acting merely as
triggers. In particular, Sornette examines financial crashes within the
framework of the "spontaneous emergence of extreme events in
self-organizing systems," noting that "extreme events are
characteristic of many... 'complex systems.'" The author
employs mathematical tools--specifically, log-periodic power laws--to
study the prebubble or precrash buildup in a financial system to its
critical point.

Efforts by nonfinancial people to analyze and explain financial
phenomena using quantitative techniques from the hard and engineering
sciences can be of tremendous use and interest to those of us in the
financial community--provided that the mathematical techniques are
applied by an author with an exposure to and understanding of the
financial instruments, processes, and markets that are being analyzed.
The author of Why Stock Markets Crash has done an admirable job of
understanding and appreciating the financial world and its nuances.
Didier Sornette is a professor of geophysics at UCLA, as well as a
research director at the National Center of Scientific Research in
France. He specializes in the prediction of catastrophic events within a
complex system framework. In this book, as well as in a portion of his
hundreds of journal articles, he takes his previous work in the physical
and geological sciences and exports his mathematical modeling and
prediction skills to the financial markets.

In the first chapter, Sornette places historical extreme financial
events--in particular, market crashes--in a complex, self-organizing
system framework. This is followed by two chapters devoted,
respectively, to the basic concepts and characteristics of financial
markets, and to some statistical analyses demonstrating that financial
crashes are essentially outliers. Chapters 4 and 5 explore positive
feedback mechanisms and describe models for speculative bubbles. In
Chapter 6, fractals and log-periodicity are introduced and discussed.
This will likely be a key point of interest for many readers. The
mathematics accelerates a bit here, but it is presented reasonably and
is not crucial to following the general argument. Chapters 7-9 build
upon the prior material by analyzing crashes in both developed and
emerging markets, and by examining the resulting possibility of
predictions of crashes and bubbles in the financial markets. Chapter 10
concludes the text by discussing some interesting issues, such as
economic and population projections, associated with the next roughly
one-half century.

There are not many equations in this book--but that is not to say
that it is not a technical read. Even skipping over the occasional
purely mathematical expositions, there is a lot of technically oriented
material to absorb. There are quite a number of graphs and charts, which
are helpful in explaining and supporting the author's arguments,
although they also have a technical aspect to them. But even if one were
to skip the most technical aspects of the book, the main thrust of the
work is clear and continuous throughout the book.

One enjoyable aspect of the book, and a manifestation of the
author's hard science background, is the occasional analogy with,
or anecdote about, the physical or life sciences. An example is an
analogy made between the concept of "efficient markets" and
the information coded into DNA. On the this-gave-me-some-pause side, the
author does occasionally reveal his hard science background with a
reference or analogy to a technical item that the general reader is not
likely to understand. Also, there is a possible danger of getting so
caught up in the mathematical modeling that one can forget about all of
the nonquantitative aspects and influences on the financial markets. But
the author, reasonably and refreshingly, realizes and acknowledges these
qualitative considerations.

In addition to generally clear and readable text, the author also
offers readers a list of 463 references, covering a wide range of
relevant material from (for example) the physics, biology, economics,
and finance literatures. Overall, a highly recommended, enjoyable,
well-researched, and thought-provoking book for anyone interested in
stock markets and the modeling of financial processes.

Reviewer: Rick Gorvett, University of Illinois at Urbana-Champaign

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